NEW YORK (AP), Dec 17 - A proposed cap on the fees that banks charge for debit card transactions would substantially reduce the cost for businesses. But it's started a death watch for debit card rewards and renewed predictions that free checking is done for.

At issue is who will ultimately benefit from the savings? The Federal Reserve's proposal to cap these fees, officially known as interchange fees, at 12 cents per transaction would enable retailers to pass on annual savings of $10 billion to $13 billion to consumers. But banks and card networks maintain that retailers will pocket the saving s. This would leave consumers to bear the brunt of the new law through higher costs for banking and reduced rewards programs.

In releasing its proposal Thursday, Fed staff said they found the cost to banks for processing is between 7 cents and 12 cents per transaction. Yet every time a customer swipes a debit card, the average fee is 44 cents.

"The banks have a very sweet deal here," said Sen. Dick Durbin, who sponsored the provision in the financial regulatory overhaul that ordered the Fed to set rules on these fees. The Illinois Democrat acknowledged that the legislation does not require merchants to share any cost reductions with customers, but said they're likely to benefit at the checkout.

"The retailer who is in competition with the restaurant around the corner is going to use this as an opportunity to lower prices," Durbin said, comparing the swipe fee reduction to a business tax cut.

If implemented, slashing interchange rates would be another revenue hit for banks. They're already dealing with increased costs linked to other regulations in the financial overhaul, plus restrictions on overdraft fees and credit cards.

Shawn Miles, group head of public policy for MasterCard Inc., said banks will have to compensate for the loss of revenue by adjusting the fees they charge consumers. "That's the only way they could deal with something that was this dramatic," he said. Wall Street and the banking industry were expecting the proposed cut would call for fee c uts of no more than 60 percent. The proposal is close to a 73 percent cut.

"A very large percent of the consumers in the U.S. have access to low- or no- cost checking accounts and debit cards that give them ubiquitous access to their funds," said Bill Sheedy, the head of Visa Inc.'s operations in the Americas. "You can't squeeze the balloon and assume that the changes being proposed by the Fed won't have a negati ve impact on how the industry operates."

Banks may see another, indirect, impact if debit fees are lowered so sharply. Analyst Burt Flickinger of Strategic Resource Group suggested many retailers will encourage consumers to use their debit cards instead of credit cards, which carry higher interchange fees that are not addressed in the law.

Industry watchers predict banks will respond by trying to make up at least some of the lost merchant revenue from consumers. Among the possibilities they are expected to test out:

- Explicit fees for debit cards, maintenance fees on the checking accounts the cards are linked to and the elimination of debit rewards programs.

Debit rewards programs are funded by interchange fees, said Bart Narter, a banking analyst with the consultant Celent. "Rewards are if not dead, then very, very sick, because funding for rewards just shriveled."

- More programs may be funded by merchants, rather than banks. There's already a trend toward merchant-funded rewards programs with popular coupon and deal programs like Groupon and Living Social, noted Jonathan Silver, CEO of Affinity Solutions, which administers about 400 rewards and loyalty programs, about 60 percent of which are linked to debit cards.

- Another option could be programs linked to other accounts at the same bank, like Citibank's "Thank You" program, which offers rewards for banking activity and credit card use in addition to debit card use; or Bank of America's "Keep the Change," program, which shifts money into a savings account when a debit card is used. "If they get cu stomer centric, they can reward you elsewhere," said Brian Riley, a bank card analyst for the consultant TowerGroup. "They have the ability to be more flexible."

Supporters of the lower fees say the loss of debit rewards won't be that painful. The programs are not that widespread. Only about 16 percent of checking accounts have programs, and an estimated 30 to 50 percent of rewards are left unused.

"We were never getting debit card usage for free, it was just a pretense," said David Balto, a senior fellow at the Center for American Progress, a left-leaning think tank. The price of interchange was simply hidden from customers because they didn't see it added to the costs of what they purchased, he said.

In countries such as Canada, where there are no interchange fees, Balto said, there are fees on bank accounts. "It's better for consumers to pay a transparent price than a hidden price."

Customers of smaller banks and credit unions may also feel a negative impact from the regulation even though smaller institutions are left out of the law and won't face a cap on their fees. "The legislation says we are carved out, but there's no real enforcement provisions," said Bill Cheney, CEO of the Credit Union National Association.

While a two-tier system with higher interchange fees for small banks may result from the regulation, that creates a new set of concerns, he said. One fear is that if small banks and credit unions charge higher fees, merchants may shun their cards. If small institutions find they have to shift to the lower fees, the revenue loss would be si gnificant, and would have to be made up from customers, Cheney said. "The last thing that credit unions want to do is raise their fees."